The Federal Reserve Bank of New York works to promote sound and well-functioning financial systems and markets through its provision of industry and payment services, advancement of infrastructure reform in key markets and training and educational support to international institutions.

The New York Fed engages with individuals, households and businesses in the Second District and maintains an active dialogue in the region. The Bank gathers and shares regional economic intelligence to inform our community and policy makers, and promotes sound financial and economic decisions through community development and education programs.

Why the Proposed Border Tax Adjustment Is Unlikely to Promote U.S. Exports

Mary Amiti, Oleg Itskhoki, and Jozef Konings

There has been much debate about the proposed border tax adjustment, in which U.S. firms would pay a 20 percent tax on all imported inputs and be exempt from paying taxes on export revenue. The view among many economists, including proponents of the plan, is that the U.S. dollar would appreciate by the full amount of the tax and thus completely offset any relative price effects. In this post, we consider the implications of an alternative scenario where the U.S. dollar only appreciates part of the way. This could happen, for example, as a result of the uncertainty surrounding the policy response from other countries. As the proposed tax is effectively equivalent to an import tax combined with an export subsidy, it is possible that there could be retaliation from other countries in the form of taxes on U.S. exports or litigation with the World Trade Organization. If the U.S. dollar does not appreciate by the full amount of the tax, we argue that the effect of the tax will be to lower both U.S. imports and exports in the short to medium run.

The reason for our conclusion is that pricing for the vast majority of contracts governing U.S. international trade, both imports and exports, is preset in U.S. dollars. Consider imports first. The border tax adjustment, which only allows for a tax deduction on domestically produced inputs, will increase the effective price of foreign-produced inputs that U.S. firms will have to pay. So firms that rely on imported inputs and sell predominantly in the U.S. market will be worse off, as intended by the policy. The appreciation of the U.S. dollar will have only a small impact to offset these cost increases, because U.S. imports are predominantly invoiced in U.S. dollars and the pass-through from currency changes into U.S. import prices is quite low, with estimates at around 30 percent or lower.

Higher prices on imported inputs are likely to result in higher domestic prices by both importing and non-importing firms. We provide evidence of “strategic complementarities” for Belgian firms, showing that a 10 percent increase in competitor prices leads to a 5 percent increase in domestic prices of large firms. This channel is also likely to be present in other market economies, such as the United States. For example, if there is a tax on imported steel, local steel producers can also increase their prices and still stay competitive relative to foreign-produced inputs. This will further increase the costs for U.S. firms and consumers.

How will U.S. exporters fare? An unintended consequence of the proposed border tax is that it is likely to depress rather than stimulate exports. As export prices are also invoiced in U.S. dollars, the tax exemption on export revenue will mostly boost exporters’ profit margins rather than increase their export sales. And with the accompanying partial appreciation in the U.S. dollar, the prices of U.S. exports in foreign currencies will rise. This will provide incentives for our trading partners to switch their demand away from U.S.-produced goods, resulting in lower U.S. export sales.

The increased exporter profit margins from the tax exemption could lead U.S. exporters to lower their dollar export prices. However, the effects are complicated by the fact that the largest exporters are simultaneously the largest importers of intermediate inputs. This is a new stylized fact that we uncovered in our paper on Belgian firms and is a pattern that is also prevalent in the United States. We showed that this pattern is important because a currency depreciation that would normally boost exports is less effective because the same depreciation increases those firms’ marginal costs as their inputs become more expensive. This same logic applies in the case of the proposed border tax. U.S. exporters that import their inputs will have to pay more for those inputs, thus offsetting some of the benefits of having their export revenue tax exempt. This effect is most significant for the largest importers, which are also the largest exporters.

In the long run, market forces are expected to undo the tax effects on import and export prices, but both will be affected in the interim. Before the U.S. dollar prices of imports and exports come down—restoring the pretax relative prices—both imports and exports will become more expensive and U.S. foreign trade will be dampened, with the net effect on the U.S. trade balance difficult to gauge. The effects will also be heterogeneous across firms, depending on whether the firms are exporters, importers, or importing exporters. But our research suggests that both firms and households will be faced with higher prices for imports and domestically produced goods alike.

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Mary Amiti is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Oleg Itskhoki is an associate professor of economics at Princeton University’s Woodrow Wilson School of Public and International Affairs.

Jozef Konings is a professor of economics at the University of Leuven.

How to cite this blog post:
Mary Amiti, Oleg Itskhoki, and Jozef Konings, “Why the Proposed Border Tax Adjustment Is Unlikely to Promote U.S. Exports," Federal Reserve Bank of New York Liberty Street Economics (blog), February 24, 2017, http://libertystreeteconomics.newyorkfed.org/2017/02/why-the-proposed-border-tax-adjustment-is-unlikely-to-promote US-exports.html.

You can follow this conversation by subscribing to the comment feed for this post.

Thank you for your comment. A salient feature of the Belgian data that we document where large exporting firms are also large importers is also prevalent in the U.S., as documented in the study we provide a link to. The economic forces that generate strategic complementarities are likely to be present in all market economies, though the exact magnitude is likely to vary and we included the findings from Belgium as an illustrative example.

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Liberty Street Economics is now available on the iPhone® and iPad® and can be customized by economic research topic or economist.

We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1500 characters.

Please be quick: Comments submitted after COB on Friday will not be published until Monday morning.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be on-topic and patient: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post. We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will not be posted.‎

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.